REPORT The Dangers of Buybacks - FCLTGlobal

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The Dangers of Buybacks

MITIGATING COMMON PITFALLS

SEPTEMBER 2020

Rewiring Capital Markets to Support Sustainable Growth

Business leaders have long struggled to weigh immediate financial needs against objectives many years into the future in order to succeed over the long term.

In the wake of the global financial crisis, something had to change in order to safeguard the future needs of individual savers and their communities. To call for action to reform the system, Focusing Capital on the Long Term (FCLT) was founded in 2013 as a joint initiative of CPP Investments and McKinsey & Company.

The initiative's message made it clear that those who participate in the capital markets could work to improve them. In July 2016, CPP Investments and

McKinsey teamed with BlackRock, The Dow Chemical Company, and Tata Sons to found FCLTGlobal as an independent non-profit.

FCLTGlobal is a non-profit organization that develops research and tools that encourage long-term investing. At the heart of our work are our Members--leading global asset owners, asset managers, and companies that demonstrate a clear priority on long-term investment strategies in their own work. We conduct research through a collaborative process that brings together the entire global investment value chain, emphasizing the initiatives that market participants can take to make a sustainable financial future a reality for all.

MEMBERS

2 | The Dangers of Buybacks: Mitigating Common Pitfalls

Table of Contents

4 Executive Summary 5 The Rise of Buybacks 7 Advantages 8 Pitfalls 1 1 Mitigating Common Pitfalls 1 3 Conclusion 1 4 Acknowledgments 1 5 Buybacks Playbook 1 6 References

This document benefited from the insight and advice of FCLTGlobal's Members and other experts. We are grateful for all the input we have received, but the final document is our own and the views expressed do not necessarily represent the views of FCLTGlobal's Members or others. The information in this article is true and accurate to the best of FCLTGlobal's knowledge. All recommendations are made without guarantee on the part of FCLTGlobal. Reliance upon information in this material is at the sole discretion of the reader; FCLTGlobal disclaims any liability in connection with the use of this article.

The Dangers of Buybacks: Mitigating Common Pitfalls | 3

Executive Summary

Returning capital to shareholders is an important and legitimate goal of many corporations. Buybacks are often an effective way to distribute capital, but care must be taken to mitigate downfalls related to personal gain and enrichment, poor timing, and excess leverage.

Buybacks have experienced a meteoric rise in popularity since the turn of the twenty-first century, overtaking dividends as the preferred means to return capital to shareholders in jurisdictions like the US. In 2019 alone, corporations spent more than USD 1.2 trillion globally on buybacks.1

But the rise of buybacks has been riddled with controversy. Academics, practitioners, and politicians alike have maligned the use of buybacks, taking issue with their potential contribution to income inequality, underinvestment in innovation, and use for personal enrichment. Buybacks and their implications for the long-term strength of the economy are controversial but not well understood. A deeper look at the topic reveals the following:

? Buybacks have become a global phenomenon over the past 20 years, with many companies viewing them as an attractive alternative to dividends in returning capital to shareholders. They are flexible, recycle excess cash to the economy, and provide tax advantages in certain jurisdictions.

? Buybacks have a number of pitfalls if not used carefully and in the right circumstances. These include:

? being used for personal gain and enrichment

? poor timing of investment decisions

? contributing to excess leverage, leading to lower levels of resilience

? Buybacks can add long-term value when the issues above are mitigated and key criteria are met. These criteria include:

? alignment with a company's long-term plan

? adequate liquidity buffers

? fulfillment of additional investment needs in talent, R&D, CapEx, and M&A

The Dangers of Buybacks: Mitigating Common Pitfalls, provides a fuller explanation of these findings, beginning with an examination of why buybacks are attractive to companies, followed by a deeper look at their pitfalls, and concluding with practical tools and guidelines for companies, investors, and policymakers to evaluate buybacks on their long-term merits.

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The Rise of Buybacks

Buybacks (share repurchases) are an increasingly popular capital allocation tool to return cash to shareholders, rising to prominence in the past 20 years.

Buybacks by themselves are neither magic bullets to increase a company's earnings per share (EPS) nor a nefarious means of enriching executives or shareholders. Buybacks, or share repurchases, are simply a financial tool. In a buyback, a company purchases its own shares from existing shareholders in the marketplace. This direct purchase of shares by the issuing company provides an alternative to dividends for the company to distribute capital to shareholders.

Buybacks are a fairly new phenomenon and have been gaining in popularity relative to dividends recently. All but banned in the US during the 1930s, buybacks were seen as a form of market manipulation. Buybacks were largely illegal until 1982, when Ronald Reagan signed Rule 10B-18 (the safe-harbor provision) to combat corporate

raiders. This change reintroduced buybacks in the US, leading to wider adoption around the world over the next 20 years.2 Figure 1 (below) shows that the use of buybacks in non-US companies grew from 14 percent in 1999 to 43 percent in 2018.

Buyback mechanisms vary, depending on the jurisdiction. While the board approves of buybacks in many jurisdictions, shareholders do have a say in certain countries, typically through an annual general meeting (AGM) vote. Figure 2 (page 6) shows the split between countries where the board approves of the buyback plan and countries where shareholders approve of the plan.

There are also multiple methods of stock repurchase, not just the repurchasing method achieved directly through the open market. While more than 95 percent of shares repurchased are through the open market, some companies also have purchased shares through tender offers and Dutch auctions.3

Overall, companies' use of buybacks is related to their capital intensity, firm age, and financial position. While each company is unique and idiosyncratic, trends over the last decade show the following:

Figure 1. Percentage of Firms Using Buybacks, US vs. Non-US4

100%

80%

60%

40%

20%

0% 1999 2000

2001 2002

2003

2004

2005

2006

2007 2008 2009

NON-US US

2010

2011

2012

2013

2014 2015

2016

2017

2018

The Dangers of Buybacks: Mitigating Common Pitfalls | 5

Figure 2. Party Approving Share Repurchases5

S H A R E H O L D E R S B OA R D

1.Buybacks have become a global tool--in 2018, their usage rate topped 50 percent in 16 different countries across six continents. (see Figure 3)

Figure 3. Percent of Companies in a Country that Executed a Buyback (2018)

0%

100%

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2.The US is by far the leader in buyback activity, and is the only country where money spent on buybacks exceeds dividends. (see Figure 4)

Figure 4. 2018 Dividends and Buybacks as a Percentage of Total Country Market Cap6

5% 4% 3% 2% 1% 0%

United China Japan United France Germany Australia States Kingdom

B U Y B AC K S D I V I D E N D S

3.Capital intensive sectors like utilities spend less of their earnings on buybacks as compared to fixed asset-light sectors like financials and information technology (see Figure 5).7

Figure 5. 2018 MSCI All Country World Index Uses of Capital by Sector

100%

26%

54%

76%

90%

80%

70%

43%

60%

50%

40%

30% 31%

20%

10%

0% Financials

15% 31%

Information Technology

22%

3% Utilities

B U Y B AC K S D I V I D E N D S A L L OT H E R

Advantages

Buybacks are a technical capital allocation tool and an attractive alternative to dividends for the following reasons.

Flexibility Unlike dividends, buybacks can be turned on and off. Whereas there is an implicit expectation that dividends generally are not cut, buybacks can fluctuate based on business results and the company's strategy.

Buybacks also provide shareholders with flexibility. Unlike dividends, which are paid out to all shareholders, buybacks only create a transaction for those who choose to sell their shares; others can opt out if they believe their shares will rise in value.10

Of note, many companies do temporarily cut or suspend dividends during a crisis for liquidity purposes.

Signaling Several academics have posited that companies use buybacks to signal that their stock price is undervalued.10 Unlike dividend signaling, companies are not committed to a constant payout at a higher level. This is most effective for small-cap companies due to information asymmetry.11

Capital recirculation Buybacks recycle cash, freeing "trapped cash" from firms in mature or capital-light industries with limited investment opportunities, allowing shareholders to reinvest in the next growing company.12 No matter how much money cash-rich companies like Apple invest back into their own company, at some point they will be left with more cash than they can productively spend.13 Constraining a company's ability to return cash to shareholders could lead a company to make poor investments in the absence of good ones, producing an inefficient allocation of resources, shrinking the overall economic pie.14

Tax advantages Buybacks often receive preferential tax treatment compared to dividends in certain jurisdictions. In these jurisdictions, buybacks are taxed as capital gains while dividends are taxed as ordinary income, meaning investors could prefer to receive buybacks over dividends.15,16

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Long-term excess returns Instead of having "millions of dispersed shareholders, whose stakes are too small to motivate them to look beyond short-term earnings," buybacks concentrate ownership and increase the equity held by large, continuing shareholders.17 These "blockholders" may buy into the company's vision and have an incentive to look at long-term growth opportunities and intangible assets instead of short-term earnings.18

Pitfalls

Buybacks are often associated with long-term value-destroying behaviors, including several means of personal gain and enrichment, poor timing of investment decisions, and excess leverage.

As attractive as buybacks may be as a method to return cash to shareholders, they are a powerful tool that can lead to serious dangers.

Executive compensation gaming A common criticism of buybacks is that they can be used by management to manipulate earnings per share (EPS), which could be used to inflate their own compensation metrics and hit quarterly guidance targets.19,20,21 Indeed, according to Institutional Shareholder Services (ISS), as recently as 2019, more than 30 percent of all compensation plans were linked to EPS.22

By using buybacks to reduce the denominator (shares outstanding), management can boost a company's EPS in the short run, assuming the numerator (earnings) remains unchanged.23

While increasing EPS may look attractive, doing so via buybacks alone is hard to sustain in the long run: companies create more value through organic revenue growth and margin improvement.24 Artificially boosting EPS can be short-term in nature, and can even siphon capital away from growth initiatives.25

While buybacks can contribute to executive compensation gaming, it is worth noting, however,

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that the problem in this instance would lie within the structure of a poorly designed compensation plan. EPS targets in compensation plans, not buybacks, could be the underlying cause of short-termism.26 Excessive buyback activity in this case is a symptom, not the root cause, of the problem.

As stated by one member of our working group, another aspect of buybacks as related to executive compensation is their use in anti-dilutive measures for employee stock issuance. FCLTGlobal has separately convened a working group of Members on executive compensation who will cover this issue, along with other related considerations. If you'd like to share your perspective on the topic, please contact research@.

Employee trading One reason buybacks were all but illegal in many jurisdictions up until the 1980s was that they were considered a form of stock manipulation. The concern was that employees with inside knowledge of the company, usually executives, could trade around a buyback announcement. Rule 10B-18 legalized share repurchases under specific conditions to discourage employees from insider trading.

While regulations to deter employee trading still exist, many have found loopholes around them, especially in the US. As an example, current rules prevent employees from trading on the same day as a buyback announcement, but executives can announce a buyback, then sell their shares a few days later. A 2018 US Securities and Exchange Commission (SEC) study found that insiders were twice as likely to sell on the days following a buyback announcement as they were in the days leading up to the announcement, and that

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